Evenlode Income – the top performing equity income fund that has never cut its dividend – is the latest portfolio to be dismissed from the IA UK Equity Income sector due to its yield criteria, with manager Hugh Yarrow (pictured) urging the Investment Association to encourage greater disclosure in regard to fund’s dividend histories. 
Currently, funds need to have a yield of 110 per cent of the FTSE All Share over rolling three-year periods in order to be members of the IA UK Equity Income sector. In addition, their yield can never fall below 90 per cent of the index’s in any one year.
For many years this criteria worked well but recent developments within the UK equity market have sparked debate as to what actually makes an equity income fund.
Indeed, thanks to an over-arching sense of nervousness since the global financial crisis, the low interest rate environment and the lack of economic growth, defensive dividend-paying companies have become increasingly expensive which has caused their dividend yields to fall.
At the same time, while the index’s yield has risen to close to 4 per cent over the last year, this is mainly due to the fact that some of its largest constituents (mining and energy in particular) have challenged dividends due to poor balance sheets and macroeconomic trends.
Dividend cover in the FTSE
Source: Canaccord Genuity Quest
Indeed, with dividend cover falling and pay-out ratios increasing, the likes of Neil Woodford have argued that the current yield on the index is “artificial” as many of the underlying dividends represented in it won’t be paid.
As such (and although it isn’t black and white) managers in the equity income space face the decision of either focusing on high quality companies with dependable dividends but being at risk of being removed from the sector due to their inevitably low yield or include higher yielding stocks in their portfolios but risk reducing their overall pay-outs to unitholders because of potential dividend cuts.
This odd market backdrop has already meant the likes of Mark Barnett’s Invesco Perpetual income funds, Schroder Income and Rathbone Income have been forced into the IA UK All Companies sector.
Though the Investment Association has launched a consultation into the sector’s criteria, the five crown-rated Evenlode Income fund – which has been a top quartile performer since its launch in October 2009, paid out more in total dividends than its peers over that time and never cut its dividend – is now also going to be kicked out from the sector due to its more defensive positioning.
Performance of Evenlode Income versus sector and index since launch
Source: FE Analytics
Yarrow, who has managed the £400m fund since launch, says the fact his fund (which yields 3.8 per cent) will move sectors at the start of June shows the Investment Association needs to revaluate how the criteria for the IA UK Equity Income peer group is put together.
“This sector move has no impact on our approach to managing Evenlode. It has not, nor ever will, result in us making any changes to the Evenlode portfolio. The move is purely driven by the fund narrowly failing a somewhat arbitrary sector classification definition,” Yarrow said.
“At Evenlode, we think an income fund works best when it delivers a balance between income today and income growth in the future. Both factors are important to the income seeking investor, and neither factor on its own is enough to generate a meaningful, sustainable and inflation-proofed income stream for the long-term saver. A balance between dividends today and dividends in the future should also drive good capital growth over time.”
Last month, the Investment Association announced it is launching a consultation on its current yield requirement rule.
There are three options outlined in the consultation. The first is to change nothing; the second is to essentially lower the bar and say funds only need to yield more than the FTSE All Share to stay in the sector; and the third is for funds to publish more in-depth income statistics (such as absolute net income over five years and income growth) to allow investors to better judge the fund’s performance.
Yarrow advocates using the third final option.
“As the IA itself stresses: ‘Market cycles and statistical calculations can conspire to produce results that seem at odds with the original intentions. There remains no intention for sector parameters to dictate fund strategies.’”
Yarrow added: “Option three seems the best option in terms of avoiding this undesired scenario.”
For example, he thinks the best way of getting past the issue is for groups to disclose the amount of income generated over five years. This, again, would show that Evenlode Income is fully deserving of a spot within the IA UK Equity Income sector.
Evenlode Income’s dividend history versus the sector average
Source: FE Analytics *figures based on a £10,000 investment in January 2011
The graph above shows that not only has Yarrow – who favours high quality, cash generative mega- caps – grown his fund’s distributions in each of the last five calendar years, he has also paid out more in total dividends than the sector average.
Investors who bought £10,000 worth of units in January 2011 would have earned £2,480 by the end of 2015 while the average fund in the sector would have paid out £2,416.
Yarrow continued: “This measure does not ‘punish’ funds that have produced good capital performance over time. Ironically, if Evenlode had only performed in-line with the UK market, the fund’s yield would have been 5.1 per cent at the end of February, rather than the actual 3.8 per cent yield.”
FE Trustnet has long argued that yield (when used in isolation) is a poor tool for assessing the viability of an income fund. The charts below highlight this dynamic.
On the left hand side shows Evenlode Income’s dividend history in pence per unit, which has steadily been increasing. On the right hand side, we show the relationship between the fund’s published yield and its unit price.
Fund’s dividend (in pence per unit), unit price and yield between 2011 and 2015
Source: FE Analytics
The right hand side line chart shows that as the unit price has increased, the published yield has fallen.
Premier’s Simon Evan-Cook, who is a unitholder in the fund, says investors need to remember the difference between yield and actual income pay-outs.
“Most people understand it, but many do forget it as well,” Evan-Cook said. “We’ve seen investors becoming disappointed when our fund’s yield has fallen. We have still been paying the same, it just our unit price has increased.”
“There needs to be a sea change about how people view income. However, Yarrow’s views and comments are all exciting developments, which is encouraging as at the moment managers are being punished and being thrown out of the sector for delivering a good and growing income, which isn’t a sensible situation.”
Yarrow and his co-manager Ben Peters have started that they will continue to run their fund in the same way and Thomas McMahon, fund analyst at FE Research, says the team at Evenlode are right to have stuck to their strategy.
“Many equity income managers are facing a dilemma: either they chase yield in stocks they view as risky from the point of view of dividend growth or capital, or their fund is removed into the IA All Companies sector,” McMahon said.
“They have a selfish interest in remaining in the IA Equity Income sector as many investors won’t look outside it for equity income solutions, so leaving could potentially hit their profits. Managers who take that risk to their business rather than putting their investors’ capital at risk should be praised.”
However, he points out that from the point of view of investors, the situation highlights why sector guides should not be at the core of any fund selection process.
“Even if the IA manages to find a new formulation that satisfies fund groups in the short term, there will inevitably be issues and problems in the future when the environment changes – the current rules were considered satisfactory until a revaluation of the market pushed yields low in many areas.”
“The All Companies sector and Targeted Absolute Return sectors are two which either have questionable members or are poor peer groups for comparison. Investors should not expect any reorganisation of the sectors to be a magic bullet that will resolve this issue but use their own judgement when constructing peer groups.”